The U.S. Securities and Exchange Commission is “asking” banks that issue structured notes to improve the accuracy of disclosures to investors, including comparing the sale price to the true (lower) value of the notes at the time of sale. “We believe issuers should consider prominently disclosing the difference between the public offering price of the note and the issuer or its affiliate’s estimate of the fair value,” the SEC said. See “SEC Seeking Fair Value Disclosure From Banks on Structured Notes,” by Matt Robinson, Bloomberg.
Structured notes are essentially bank bonds bundled with derivatives. Derivatives are contracts whose value is derived from stocks, bonds, currencies and commodities. Thus, structured notes are complex products with no pricing transparency.
Like nontraded REITs, another type of illiquid and opaque alternative investment, structured notes have been misleadingly valued at the purchase price on statements sent to customers when the true value is actually lower.
Structured notes and nontraded REITs have often been sold to investors who do not understand them by selling agents who do not understand them and who cannot explain them properly to investors.
As a result, many investors have unwittingly been induced to invest in high-risk investments at inflated prices.
In a letter that shows the SEC is “onto” the banks’ tricks, it asked the bank-issuers of structured notes to explain a number of things to investors, including, among others:
- the stated value (purchase price) of the notes at issuance versus the price the bank would actually pay for the notes in the secondary market;
- why the bank uses values on account statements that exceed its own estimate of the true value of the notes;
- what the bank plans to do with the money being lent to it by investors, and how important that money is to the bank’s maintaining sufficient liquidity;
- why notes are sold to investors at differing prices, and what type of investor may receive a “better” price;
- how often the bank offers to buy back notes from investors prior to maturity, the price paid, and how that price is determined; and
- the fact that the notes are solely the unsecured obligations of the bank-issuer and subject to a bank-issuer’s credit risk with no ability to pursue a referenced asset for payment.
The letter was sent by the Office of Capital Market Trends, which is part of the SEC’s Division of Corporation Finance. The office was reportedly created in July 2010 and is headed by Amy Starr.
“The SEC finally understands these products,” Frank Partnoy, a University of San Diego law professor and former Morgan Stanley derivatives structurer, was quoted as saying, adding: “I’m very encouraged by these questions that the SEC is asking.”
Partnoy observed that if banks start making the disclosures that the SEC wants, investor demand for structured notes will decline.
“The secondary market for structured notes is completely opaque, and people don’t have an accurate understanding how much they are worth the day after you buy them,” Partnoy said.
The Financial Industry Regulatory Authority (FINRA) has admonished its member firms about their responsibilities in supervising sales of “complex products,” citing some structured notes as examples. As many as 10 states are reportedly investigating how structured notes are marketed.
Page Perry, LLC is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.